Tips on TIPS

ANNANDALE, Va. (CBS.MW) -- One of the three most recommended mutual funds among investment newsletters is a bond fund -- Vanguard Inflation-Protected Securities.

The fund
VIPSX, -0.31%
currently is recommended for purchase by nine of the newsletters monitored by the Hulbert Financial Digest.

We might surmise from this fund's popularity that these newsletters are bearish on stocks for 2004. After all, if the stock market is as strong this year as many are forecasting, then interest rates are likely to go up -- which in turn would be bearish for bonds.

But we would be wrong.

Almost to a man, the nine newsletter editors who currently are recommending VIPSX are bullish on stocks.

Why, then, are they recommending a bond fund?

Their answer, in a word, is diversification. Though they expect the stock market to rise in 2004, they also acknowledge that there are no guarantees. Therefore, they in essence are saying, it behooves us to have some exposure to the bond market as insurance against another bear market in stocks.

Nevertheless, these editors also recognize that this calls for investing in bonds at a time when interest rates are at multi-decade lows -- advice that seems counterintuitive at best. As a compromise, they are recommending inflation-protected bonds -- which, when issued by the U.S. Treasury, are known as TIPS (for Treasury Inflation Protected Securities).

These advisors find it easier to advise the purchase of TIPS than regular bonds because, to the extent that interest rate increases this year are accompanied by increases in inflation -- which seems likely -- then inflation-protected bonds should suffer less than those that are not indexed to inflation.

As the Morningstar Vanguard Fund Family Report recently put it, "as the economy gains traction, the specter of inflation is likely to loom large. Thus, for those investors with a suitably long time horizon and a stomach for a few bumps along the way," inflation protected bonds are "a great option."

These advisers' rationales go to the heart of what makes TIPS unique. In contrast to regular bonds, which are vulnerable to a rise in nominal interest rates, inflation-protected bonds are vulnerable to a rise in real (inflation-adjusted) interest rates.

In other words, the kind of interest rate rise to which inflation-protected bonds are vulnerable is the kind that is not accompanied by a corresponding increase in the inflation rate.

To state these advisers' argument in different terms, therefore, they believe that an increase in nominal rates is more likely than an increase in real rates.

A quick review of the data suggests that, at least from a long-term perspective, these editors have history on their side. The graph shows how both nominal and real interest rates have fluctuated since 1914.

The nominal interest rates are based on 6-month commercial paper or certificates of deposit; real interest rates were calculated by subtracting year-over-year percentage changes in the consumer price index.

Notice that while nominal 6-month interest rates are a close to 90-year lows, real interest rates are not. Nominal rates today are lower than at any time since the 1930s and 1940s, and even in those years, rates were only marginally lower than today's.

In contrast, real rates in the 1920s, 1950s, and 1970s were lower than those prevailing today, sometimes significantly so.

Therefore, on a relative basis, at least judged from the perspective of short-term interest rates, it does seem fair to say that inflation-protected bonds have less downside risk than regular bonds.

But note that there still is absolute risk. The average level of real rates over the last 90 years is 1.3 percent, which is higher than current levels.

To be sure, Vanguard's inflation-protected bond fund is not the only mutual fund that invests in this sector of the bond market. However, none of the others enjoys any where near the popularity among investment newsletters that Vanguard's does.

For example, there are two other inflation-protected bond funds that are recommended by investment newsletters on the HFD's monitored list -- Fidelity Inflation Protected Bond
FINPX, -0.26%
and American Century Inflation Adjusted Bond
ACITX, -0.26%

However, in contrast to VIPSX, which currently is recommended by nine of the HFD monitored newsletters, these other two funds are recommended by just one newsletter each.

Editor's note: The most recent edition of the Hulbert Financial Digest is now available by either e-mail or regular mail. Highlights this month include:

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